Modest capital flows to Middle East region affected by geopolitics

According to the World Bank, the Middle East and North Africa had the lowest investment returns on FDI compared to other regions of the world, which, together with the uncertainty surrounding the build-up to war in Iraq and the continuing Israeli/Palestinian conflict, eroded investor confidence and posed obstacles to sustained FDI flows.

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By  Massoud Derhally Published  April 3, 2003

While foreign direct investment and migrant workers sending part of their paycheck back home have become more important sources of finance for developing countries than private lending, capital flows to the Middle East have remained modest, affected by the conflict in Iraq, says a new World Bank report, Global Development Finance 2003.

In 2002 payments on private debt were again larger than new loans, so private debt flows were a net negative for developing countries, the report said.

According to the report, net private debt flows to developing countries, bonds and bank loans, peaked at about $135 billion a year in 1995-96 and have since declined steadily, becoming net outflows in most years since 1998. Net debt flows from private sector creditors were negative again in 2002 developing countries paid $9 billion more on old debt than they received in new

In the Middle East and North Africa region however, capital flows have traditionally been modest, with FDI flows estimated to be in the order of US $2 billion to $3 billion per year in recent years, and net private debt inflows of $2.9 billion and $2.8 billion in 2001 and 2002 respectively. "This modest scale of private capital flows has reduced the region's exposure to sharp volatility and associated currency and financial crises," said the report.

The Middle East and North Africa had the lowest investment returns on FDI compared to other regions of the world, which, together with the uncertainty surrounding the build-up to war in Iraq and the continuing Israeli/Palestinian conflict, eroded investor confidence and posed obstacles to sustained FDI flows.

The region nevertheless does carry potential for larger private capital flows as indicated by the recent successful sovereign bond issues by Qatar,Bahrain, Iran and Egypt. They helped broaden the region's investor base and established benchmarks for the corporate sector to tap the market with greater confidence.

Globally, although net FDI has slipped from a 1999 peak of $179 billion to US $143 billion in 2002, it remains the dominant source of external financing for developing countries. Net portfolio flows were $9 billion, bringing total equity flows (FDI and portfolio) to more than $152 billion. Workers' remittances reached $80 billion in 2002, up from $60 billion in 1998.

The increased reliance on FDI is generally positive for developing
countries, since FDI investors tend to be committed for the long haul and are better able than debt holders to tolerate near-term adversity. Many governments that previously borrowed abroad are instead borrowing domestically, on shorter maturities. While this reduces their foreign exchange risk, the shorter-term debt increases the risks from local interest rate fluctuations and the reluctance of local investors to roll over exposures at times of stress, the
report said.

And while FDI tends to be less volatile then debt, its stability cannot be taken for granted, since both domestic and foreign investment depend on a positive investment climate.

"The shift from debt to equity highlights the importance of developing countries' efforts to foster a sound investment climate," says Nicholas Stern, World Bank Chief Economist and Senior Vice President for Development Economics. "Nine-tenths of investment in developing countries comes from domestic sources. But domestic investors' needs for a positive working environment are similar to
those of foreign investors. Both seek stable macro conditions, access to global markets, reliable infrastructure, and sound governance, including restraints on bureaucratic harassment and corruption."

A positive investment climate is also important for effective utilization of workers' remittances. In countries with poor investment climates, remittances are more likely to be spent on just "getting by" while in countries with good investment climates recipients are more likely to invest in the farms and small and medium enterprises that are key to poverty reduction.

"A positive investment climate is important for the effective utilization of all types of capital flows, including FDI, remittances, aid and debt," says Stern.

Like FDI, remittances are a more stable source of external finance than debt. Indeed, remittances tend to be counter-cyclical, buffering other shocks, since economic downturns encourage additional workers to migrate abroad and those already abroad increase the amount of money they send to families left behind. For most of the 1990s, remittances have exceeded official development
assistance. Recent trends, including tighter restrictions on informal transfers and lower banking fees mean that remittances through the banking system are likely to continue to rise.

The Middle East and North Africa region is both an important source and a significant destination of workers' remittances. Saudi Arabia, Kuwait, Oman and Bahrain have in recent years been important sources of remittances to other developing countries, including to other countries in the region. Countries receiving large remittances include Morocco ($3.3 billion), Egypt ($2.9 billion), Lebanon ($2.3 billion), Jordan ($2 billion) and Yemen ($1.5 billion).

In 2002, the region received $14 billion in remittances totaling 2.2% of GDP, ranking among the highest in the world.

"Migration and labor mobility are critical for the region. With unemployment averaging close to 20%, and with youth unemployment rates close to twice the national averages, increasing labor mobility is altogether essential, to avert poverty and to stem the disillusionment of a generation of young workers," says Mustapha Nabli, World Bank Chief Economist for the Middle East
and North Africa. "The willingness of countries in the region to continue to press forward with difficult reforms is always balanced by this tremendous concern about labor markets. Facilitating labor mobility must be addressed
hand-in-hand with other aspects of reform."

There is some evidence that remittances have been increasingly used for investment purposes in the Middle East and North Africa. In Egypt, for example, a large proportion of returning immigrants in the late 1980s established their own enterprises using funds earned abroad. Given the geopolitical risk of war and conflict however, developing countries in the region who provide workers to countries such as Kuwait and Saudi Arabia are likely to experience declines in
remittance flows. Remittance flows to Jordan and Yemen from Kuwait and Saudi Arabia declined during the Gulf War.

Despite the relative strength of equity flows and remittances globally, adapting to weak private debt flows poses a challenge for many developing countries that have come to rely on foreign loans. The net $9 billion that developing countries repaid private-sector creditors in 2002 came on top of a 2001 figure of almost $25 billion.

While it is likely that the third quarter of 2002 marked the bottom of the current credit cycle, any rebound is likely to be hesitant. Net debt flows to developing countries are likely to be broadly flat in 2003.

Growth performance over the past 18 months has differed substantially across the major regions of the developing world, largely due to differences in domestic conditions, said the World bank.

In developing countries, growth stood at 3.1% in 2002, up by a small 0.3 percentage points from weak 2001 results. Growth was restrained by the lackluster recovery in the rich countries and by financial and political uncertainties in several large emerging markets. World trade grew by a meager 3%, while prices for non-oil commodities rose by 5.1%

For oil importers, the rise in oil price from $19 to $28 per barrel over the course of 2002, more than offset gains in agricultural and metals prices. The baseline forecast projects growth in developing countries to accelerate to 4% in 2003 and to 4.7% in 2004.

In the Middle East and North Africa region, military intervention in Iraq represents the latest in a series of shocks in recent years. Regional growth fell to 2.3% in 2002, from 3.2% in 2001. Diversified exporters in the Maghreb and Mashreq experienced a sharp economic slowdown in 2002 as a result of lower export prices and lagging demand in European markets, plus the substantial shock
to tourism linked to the September 11 attacks. Growth for these exporters declined by half from 4.3% in 2001 to 2.2% in 2002.

For oil exporters, lower OPEC quotas were offset by marginally higher prices, and GDP growth remained virtually unchanged in 2002.

"MENA has had a legacy of conflict ? the general uncertainty that has blanketed the region, especially since September 11, has seriously dampened tourism, transport, and foreign capital flows into the region," explains Nabli.

"The current military action in Iraq has heightened that uncertainty to a level perhaps not seen before, with significant negative impact on growth prospects throughout the region."

The bank said, growth prospects were contingent on political factors. More broadly, the short-term growth prospects for developing countries, the bank said, will continue to depend heavily on the outlook for high-income countries, which in turn will be influenced by geopolitical factors.

Some disruptions from military actions in Iraq, including a temporary rise in the oil price, are built into the forecasts, but no severe, lasting dislocations are assumed. Based on these assumptions, growth in rich country GDP is expected to accelerate from 1.4% in 2002 to 1.9% in 2003, reaching near-term peak rates of 2.9% by 2004 before easing to 2.6% in 2005.

For the Middle East and North Africa, current projections for both oil producers and diversified exporters are for a modest pick up in economic growth to a range of 3.4 to 4% per year over the 2003-05 period, as exports rise and higher incomes stimulate domestic spending. There are, however, three main downward risks to this outlook: (i) the possibility that the pace of domestic reforms may slow down in the aftermath of the conflict as governments find it difficult to address the more controversial structural reforms that are critical for raising productivity and promoting diversification; (ii) the persistence of a negative investor outlook toward the region, causing difficulties in attracting FDI and other forms of capital flows; and (iii) that the war itself lasts longer than envisaged.

Financial conditions facing developing countries are expected to be a little less austere in 2003 than in 2001?02. Flows of FDI are projected to rebound slightly, while net flows from private sources should be modestly positive, albeit still quite anemic. As noted, this outlook is based on the assumption of a quick resolution to the situation in Iraq and a significant decline in the oil price as 2003 progresses.

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